Phantom Stock: The Scary Truth About Your Stock Options

Phantom stock, a type of equity compensation, is gaining popularity among privately held companies. They resemble regular stock options in that they allow employees to benefit in the future appreciation of the company. However, phantom stock does not actually give employees ownership of company stock.

“Fugayzi, fugazi. It’s a whazy. It’s a woozie. It’s fairy dust. It doesn’t exist. It’s never landed. It is no matter. It’s not on the elemental chart. It’s not f#!?ing real.”

Instead, they more closely resemble cash compensation based on the increase in value of the company’s stock over time.

But you still get capital gain treatment on the sale of phantom stock right? Wrong! That’s the scary part of phantom stock. You may expect a lower tax rate on your phantom stock but you’ll be in for a surprise tax bill.

What is Phantom Stock?

Companies use phantom stock options to provide employees with a financial incentive to work towards the company’s success, while not actually giving up the ownership of the company. By offering phantom stock options, companies can offer employees all the financial benefits of regular stock options but without the added administrative and legal cost of issuing actual shares.

Employers generally award phantom stock as part of an employee’s overall compensation package. Employers may also give an employee the option to defer an annual bonus by purchasing phantom stock.

For example, an employee might have the option between receiving their annual bonus of $10,000 or defer the bonus by purchasing phantom stock. If the company’s stock price increases by 20%, the employee would receive a future cash bonus equal to $12,000.

Tax Treatment of Phantom Stock

Phantom stock is treated as deferred compensation under section 409A rather than stock options. In other words, the sale of phantom stock is taxable wages not preferential capital gains. For some context, most individuals earning between $40,000 to $450,000 will have a capital gains tax rate of 15%. W-2 earnings between $40,000 and $450,000 could be subject to a tax rate of 22% – 35%. Additionally, wages are subject to FICA tax:

• 6.2% Social Security tax on the first $160,200 of wages, plus
• 1.45% Medicare tax on the first $200,000 of wages, plus
• 2.35% Medicare tax on all wages in excess of $200,000

Stock Options in Name Only

Your stock options might be phantom stock without you even knowing. Many well intended employers setup an equity compensation plan without realizing that the payments will be wages and not the sale of stock.

For example, let’s say your employer wants to reward you for being with the company for 20 years. After all, you are just as responsible for the success of the company as the original founders. In an attempt to reward you for your service your employer creates an equity based compensation agreement. In the agreement you receive 10,000 shares of non-voting stock valued at $1,000,000. The stock will vest upon your retirement and you will sell back 1,000 shares per year to the company at the stock’s original value, not at it’s current fair market value (FMV).

Because this agreement is formula based and has substantial restrictions it will be treated as deferred compensation, not as an actual sale of stock. Capital gains treatment only applies to the transfer of property. This agreement more closely resembles a cash bonus because it’s based on a current value and not based on the actual future FMV of the stock.

How to Check Your Stock Options?

One way to determine if your stock options are real stock options or phantom stock options is by reading your equity compensation agreement. If the agreement mentions the plan is governed by 409A it’s most likely deferred compensation. If the plan allows for an 83b election then it’s probably not phantom stock.

However, the easiest way to determine if your stock options will get preferential capital gain treatment is by consulting your tax advisor. You can spend hours reading through your equity compensation agreement but you won’t get a definitive answer. Even your employer might not know the tax treatment of the arrangement. Make sure to consult with a trusted tax advisor regarding your stock options.